Inheritance Tax (IHT) is rarely a welcome subject, but with the nil rate band frozen at £325,000 since 2009 and property values rising, a growing number of estates are being caught in the net.
One of the most useful and most under-used reliefs available is the normal expenditure out of income exemption, often called “gifts out of regular income”.
Used properly, it can move significant sums out of your estate immediately, with no seven-year rule to worry about.
What is the exemption?
In most cases, gifts made during your lifetime are treated as Potentially Exempt Transfers (PETs). They only fall outside your estate for IHT purposes if you survive seven years from the date of the gift.
The normal expenditure out of income exemption works differently. Gifts that meet its conditions are immediately outside your estate, regardless of how long you live afterwards.
There is also no upper limit on the amount, provided three conditions are genuinely met. A gift must:
- Be made out of your income, not capital
- Form part of a regular pattern of giving or be made with the clear intention of becoming so
- Leave you with enough income to maintain your usual standard of living
The “regular pattern” condition is the one most people misunderstand. The gifts do not need to be identical amounts on identical dates, but they should follow a recognisable rhythm.
Monthly contributions to a grandchild’s school fees, annual gifts to children to support their pension contributions or quarterly payments into a trust are all common examples.
Why income, not capital, matters
The exemption applies only to gifts out of surplus income. This typically means salary or pension income, interest from savings and investment income such as dividends and rent. Withdrawing from an ISA or selling shares to fund a gift would generally be treated as a capital gift.
Done sensibly, regular surplus income (after tax and normal living costs) can be passed on year after year with no IHT liability.
The importance of evidence
On death, executors will need to demonstrate to HMRC, using form IHT403, that the gifts were genuinely out of income and part of a regular pattern.
Good practice includes:
- A written statement of intent at the start of the gifting pattern
- A clear annual record of income and expenditure
- Bank statements showing the income source and the gift leaving the same account
- Evidence that the donor’s standard of living was maintained
This is an area where otherwise valid claims regularly fail for want of clear documentation.
Why it is worth doing now
With unspent pension funds set to be brought into IHT from April 2027 and the nil rate band frozen for the foreseeable future, more estates than ever face a 40 per cent tax charge.
Using the normal expenditure out of income exemption year after year is one of the most powerful but overlooked ways to bring that future bill down.
